Your Home Is An Asset - But Not An Investment Asset

Clients ask us all the time about either keeping a house they used to live in and renting it out or buying a house to rent out. I guess us Americans have some kind of burning desire to control our section of the Monopoly board. Usually I begin my response with a flip answer such as, “A mutual fund won’t ever call you at 3:00 in the morning with a stopped-up toilet.” And, while the hassle of managing rental property can’t be overlooked, let’s concentrate on the numbers of residential real estate as an investment.

First, let’s assume you can find renters that are suitable – won’t burn the furniture when the Cats win big, for starters – and there are no gaps between renters when you have to pay the mortgage out of your own pocket. Second, let’s assume they pay rent high enough to cover not only the mortgage but also the property tax and homeowner’s insurance. This is no small assumption because, if a renter is willing to pay rent sufficient to cover all those costs, it begs the question why they don’t simply own a house themselves.

Now, some math:

• Your former home is currently worth $250,000 and we project it to increase in value at roughly the rate of inflation – which is what residential real estate typically does over time. Generously estimating inflation at 3% (higher than in recent years) your house will be worth approximately $336,000 after 10 years.
• Now, most experts estimate that the average annual expense to maintain a home – heat and air maintenance, painting inside and out, roof maintenance, etc. – is between 1% and 4% per year. Let’s skimp on this and estimate annual maintenance costs of only 1% per year - $2500 per year and $25,000 over our 10-year example.
• The value of your house after 10 years of perfect renters is $336,000, an increase in value of $86,000 over the original $250,000 value. When we factor in $2500 of maintenance costs per year then calculate a rate of return over 10 years, you end up earning a paltry 2.12% per year. Of course, if maintenance costs are higher than 1%, your return would be even lower. Or, if there was a gap between renters…

Compare:

Ultimately, the purpose of finance is to determine where to deploy limited capital to achieve the highest rate of return over time. Instead of renting it, let’s assume that you sold that house and invested the $250,000 in a diversified portfolio of stock and bond mutual funds designed for your circumstances and time horizon and that portfolio earned an average annual rate of return of 7% per year – a reasonable expectation over time. At that rate, your $250,000 would be worth $491,787 at the end of 10 years. $155,787 more than your house after renting it for 10 years!

Being extra conservative and assuming just a 5% average annual rate of return, your diversified portfolio would be worth $407,223 after 10 years – $71,223 better than your house.

Obviously, this is just one example and ignores items such as capital gains taxes and uses simple averages when life rarely comports exactly with averages, but it does provide real life perspective. This is not an argument against owning your own home as your personal residence. Just remember, for financial planning purposes, our homes should be viewed as our castles, not our pots of gold.

Steve Byars, CFP®